ECONOMICS 100B
Professor Steven Wood
03/17/11
Lecture 18
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LECTURE:
Today’s lecture
focuses on the
Taylor Principle
and Inflation Stability.
TAYLOR PRINCIPLE:
The Taylor Principle says that in order to stabilize
inflation, the central bank will
raise the nominal
interest rate by more than any rise in expected
inflation.
This way, the real interest rate rises
whenever there is a rise in inflation.
Failure to follow the Taylor Principle means that
nominal interest rates rise by less than the inflation
increase, causing real interest rates to fall.
This
leads to an increase in equilibrium output,
resulting in even higher inflation.
FAILURE TO FOLLOW THE TAYLOR
PRINCIPLE:
If there is a temporary negative supply shock, the
SRAS curve will shift up to SRAS
1
on the AS/AD
diagram. At the new short-run equilibrium
intersection of AD
0
and SRAS
1
, output increases to
Y
1
and inflation increases to
π
1
.
If the central bank fails to follow the Taylor
Principle on the MP curve, an increase in inflation
to π
1
will result in a lower real interest rate r
1
. The
MP curve will have a negative slope. On the IS
curve, a lower real interest rate r
1
translates to
higher output at Y
1
. On the AD diagram, higher
output at Y
1
and higher inflation at π
1
results in an
upward sloping AD curve.
Now, because inflationary expectations have
increased, the SRAS curve will shift up again from
SRAS
1
to SRAS
2
. The new short-run equilibrium
will be found at the intersection of SRAS
2
and AD
0
,
with output at Y
2
and even higher inflation at π
2
.
Overall, as long as the central bank fails to raise
real interest rates in accordance with inflation,
economic output will continue to increase, as will
inflation.
Failure to follow the Taylor Principle
will lead to increasing economic output and
accelerating inflation.

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